Chapter 14: Balance-of-Payments Adjustments: Fixed Exchange Rates1

Chapter 14
BALANCE-OF-PAYMENTS ADJUSTMENTS:
FIXED EXCHANGE RATES

Chapter Overview

This chapter considers balance-of-payments adjustments under fixed exchange rates.Because persistent balance-of-payments disequilibria tends to have adverse economic consequences, there exists a need for adjustment.

The chapter notes that balance-of-payments adjustment can be classified as automatic or discretionary.Under a system of fixed exchange rates, automatic adjustments can occur through variations in prices, interest rates, and incomes.The demand for and supply of money can also influence the adjustment process.

The foreign repercussion effect refers to a situation in which a change in one nation’s macroeconomic variables relative to another nation’s will induce a chain reaction in both nations’ economies.

The disadvantages of the automatic balance-of-payments adjustment mechanism are noted in the chapter.Nations must be willing to accept adverse changes in the domestic economy when required for balance-of-payments adjustment.Policy makers must forgo using discretionary economic policy to promote domestic equilibrium.

Finally, the chapter considers the monetary approach to the balance of payments as an alternative, rather than a supplement, to traditional adjustment theories.It maintains that, over the long run, payments disequilibria are rooted in the relationship between the demand for and the supply of money.Adjustment in the balance of payments is viewed as an automatic process by the monetary approach.

After completing the chapter, students should be able to:

  • Identify the adverse effects that persistent balance-of-payments disequilibriums have on an economy.
  • Discuss the automatic adjustment mechanisms in the balance of payments that occur under a system of fixed exchange rates.
  • Describe the disadvantages of the automatic adjustments of the balance of payments.
  • Explain why the monetary approach to the balance of payments is an alternative to traditional adjustment theories.

Brief Answers to Study Questions

1.Balance-of-payments adjustment concerns the return to payments equilibrium after the initial equilibrium has been disrupted.Deficit countries face adjustment incentives due to limited quantities of international reserves and limited willingness of trading partners to lend to the deficit country.Once a surplus country believes its stocks of international reserves or overseas investments to be adequate, it generally is reluctant to run prolonged surpluses.

2.Automatic balance-of-payments adjustments consist of changes in domestic prices, interest rates, and income.The impact of money on the balance of payments is also considered an automatic adjustment mechanism.

3.The quantity theory of money is a theory based on the equation of exchange that hypothesizes that a change in the money supply will cause a proportional change in the price level.Under the classical gold standard, a nation with a payments surplus would experience gold inflows and an increase in its money supply.This leads to an increase in domestic prices, a worsening of the country’s competitive position, a decline in exports, and a rise in imports.The opposite sequence of events applies to a deficit country.

4.Changes in interest rates promote balance-of-payments adjustments via their impact on short-term capital movements.

  1. The so-called rules of the game resulted in central bankers agreeing to reinforce and speed up the automatic balance-of-payments adjustment mechanism that existed under the gold standard.In practice, they were not closely adhered to during the gold standard era.
  2. The income adjustment mechanism suggests that a nation with a payments surplus would face rising income levels and increased imports, thus tending to eliminate the payments surplus.The opposite applies to a deficit nation.

7.The foreign repercussion effect suggests that in a two-country world, a change in the level of trade of Country 1 affects the level of income of Country 2.This in turn affects the level of trade and income of Country 1.

8.A main problem of the automatic adjustment mechanisms is that a country must be willing to accept domestic inflation or recession when balance-of-payments adjustment requires it.

9.The monetary approach suggests that economic policy affects the balance of payments through its impact on the domestic demand for, and supply of, money.A policy that increases the supply (demand) of money relative to the demand (supply) for money will lead to a payments deficit (surplus).

10.The monetary approach suggests that a nation’s central bank can influence the balance of payments through changes in the money supply.However, nonmonetary policies (such as tariffs) are unnecessary since balance-of-payments disequilibriums are self correcting.

Suggestions for Further Readings

Ali, S. Capital Flows, Saving, and Investment in a World Economy. New York: Fordham University Press, 1998.

Bordo, M.D., and A.J. Schwartz, eds. A Retrospective on the Classical Gold Standard, 1821-1931. Chicago: University of Chicago Press, 1984.

Bosworth, B. Saving and Investment in a Global Economy.Washington, D.C.: The Brookings Institution, 1993.

Buch, C., et al. Foreign Capital and Economic Transformation: Risks and Benefits of Free Capital Flows. Ann Arbor, MI: The University of Michigan Press, 1999.

Cooper, R.N. The International Monetary System. Cambridge, MA: MIT Press, 1987.

Davidson, P. International Money and the Real World. New York: St. Martin’s, 1992.

Dornbusch, R. Open Economy Macroeconomics. New York: Basic Books, 1980.

Gomes. L. The International Adjustment Mechanism.New York: St. Martin’s, 1993.

Eichengreen, B. Globalizing Capital. Princeton, N.J.: Princeton University Press, 1996.

Hawtrey, R.G. The Gold Standard in Theory and Practice. London: Longmans, Green, 1947.

Krugman, P. Has the Adjustment Process Worked? Washington, D.C.: Institute for International Economics, 1991.

McDonald, R., and M. Taylor, eds. Exchange Rates and Open Economy Macroeconomics. New York: Basil Blackwell, 1989.

Mizen, P. and E. Pentecost, eds. The Macroeconomics of International Currencies. Brookfield VT: Ashgate Publishing Co., 1996.

Officer, L. Between the Dollar-Sterling Gold Points: Exchange Rates, Parity, and Market Behavior. Cambridge, MA: Cambridge University Press, 1996.